Why Hockey's call for tax cuts to fuel growth is a flawed argument

In his recent speech on personal income tax cuts, Treasurer Joe Hockey made clear that the “common cause of reform [of the tax system is] to improve the growth trajectory of the Australian economy”. The key to this for Hockey is to ensure the income tax system is not constraining workforce participation and effort, through things such as bracket creep.

Hence the need for a downward revision of personal income tax rates.

Sounds quite straightforward and reasonable, not least because it’s addressed to the average income earner.

Much of the commentary about Hockey’s speech appears to centre on the question of how any income tax cuts would be paid for. While this is an important question there’s a need to dig a little deeper.

Hockey’s speech actually highlights some fundamental questions about how we think economies such as our own behave and about the role of government, including how best to bring the tax system to bear on the task of achieving sustainable strong growth.

In this regard, there are two major concerns with the Hockey argument.

The first has to do with the view of the public sector and its economic role, or lackthereof. And this is at the heart of the question of how the tax cuts are to be paid for.

One might call this, for want of a better term, the “conservative view” of the role of the public sector: lower taxes presumably as a proportion of GDP are essential for stronger growth and this will require lower expenditure by government as a proportion of GDP, if we are to avoid a build-up of public debt.

Yes, as you guessed, the conservative paranoia in this country about public debt (a faith in search of an economic argument and which was defined by the “budget emergency” rhetoric of the Coalition’s first budget) is part and parcel of this rationale.

In this view, the key challenge for tax reform is tackling the so-called “expenditure problem”.

This view finds its justification partly in the suggestion, which Hockey himself makes explicit in his speech, that “government spending is hardly an economic value-add”.

From the standpoint of any coherent economic theory, this is truly a bizarre claim.

To twist slightly a fabled economic proposition, even getting public servants to dig holes in the ground and fill them up again generates income, as the wages of those public servants are spent on goods and services.

Of course, better to have public servants employed in the provision of socially useful services than dig holes, but the economic point remains, as Keynes noted long ago.

And, as others have noted, paying for the tax cuts via spending restraint seems problematic. The burden of that restraint (in terms of eroding the social wage) presumably falls more on lower and middle income earners, including those whose effort you are trying to harness with tax cuts.

Reading between the lines, Hockey’s counter to this kind of concern seems to be that the necessary spending restraint will be less insofar as tax cuts foster growth, that growth in turn paying for tax cuts over time and providing the revenue to fund expenditures.

But this brings into play the second major concern about Hockey’s argument, specifically about the way in which tax cuts assist growth.

Here we find lots about workforce participation and incentives in Hockey’s speech. But the problem with this kind of argument is that providing incentive for people to work more may be a necessary condition for growth but it’s not sufficient.

You can give lots of people incentive to work more and produce more. The question is whether anyone will buy the extra output and hence whether spending by households and firms would pick up.

At issue here is what you think drives growth. Hockey is channelling a contestable view of growth, namely, that increasing the effective growth of the labour force will drive growth.

The alternative would suggest that the key (which markets do not trigger automatically) to growth is growing demand and that if tax cuts are to assist growth it will be by assisting spending by households.

But the size of this effect will depend on who’s getting the tax cuts.

If the tax cuts are paid for partly by expenditure restraint on health, welfare and education and partly by regressive indirect taxes such as the GST, without compensation, the benefits to spending are likely to be negligible, since the benefits will be less to those who have a higher propensity to spend their disposable income.

And cuts to expenditure will work against growth. Indeed, any expenditure cut will always have a larger negative impact on demand for goods and services, dollar for dollar, than a personal tax increase.

The debate on tax reform is certainly one that needs to be had and an essential one for policy which fosters growth. Yet, in the current environment, getting to the economics and sorting out the precise socio-economic role of government means negotiating - as usual - an ideological minefield.